Discussion of ERCOT Market Default Alternative to Credit Insurance

1. Discussion of ERCOT Market Default Alternative to Credit Insurance CWG/MCWG September 17, 2014

2. ERCOT Collateral Coverage • Currently ERCOT Protocols provide for collateral based on historical settlement point prices, low (or ‘normal’) historic prices result in collateral requirements which will not cover an ‘unusual’ pricing event. • These events may be rare but they are not unforeseen and it is a ‘design feature’ of the current market structure that events occur frequently enough to properly incentivize new generation or demand response. • Collateral may be held for extended (and potentially unnecessary) periods after an ‘unusual’ pricing event has passed.

3. ERCOT Collateral Coverage (cont.) • During times of non-volatile market pricing, ERCOT collateral requirements more than cover outstanding invoices and active monitoring and collateral calls minimize ERCOT risk of default. • During even brief (as little as an hour or two) increases in prices to System-Wide Offer Caps, certain market participants who are ‘short’ may see their credit exposure – as measured in unpaid invoices - increase well beyond their posted collateral. • ERCOT imposes a ‘double whammy’ of having to post collateral to reflect unpaid invoices (“Current Credit Exposure”) as well post an amount to reflect ‘potential’ future exposure with projected continued higher prices (“Future Credit Exposure”). • Market participants subject to these additional postings have two days to provide additional collateral before being declared ‘in breach’ and having (proposed) one more day to ‘cure’.

4. Example of Current ERCOT EAL Credit Methodology Performance in a Pricing Event Scenario • The following graph shows how the existing ERCOT EAL credit exposure methodology performs during a pricing event. • Pricing Event Scenario: • Participant is short 800MW for hour ending 17 every day. • Participant’s behavior results in a daily actual exposure of approximately $50,000 when prices are normal (~$50/MWh). • A pricing event occurs on day 15 where hour ending 17 clears at $9,000/MWh.

5. The current EAL methodology may prevent a participant from accruing exposure for multiple events but it does little to reduce exposure to the current event. Pricing event occurs on day 15, daily actual exposure increases to $7.2MM Daily actual exposure = $50,000 Collateral = $100,000

6. ERCOT Counterparty Risk Exposure • A single pricing event of any duration may find a significant number of market participants with unpaid invoices greater than posted collateral. • Some market participants may be unable to post substantially increased collateral (to cover current and ‘projected’ future credit exposure). • Any non-payments in full of additional collateral (after the breach and cure process) would result in losses to the market in the event that posted collateral was exceeded by unpaid invoices before and during a mass transition. • These losses could be significant depending on the duration of the pricing event, the risk exposure of each defaulting counterparty, and the number of defaulting counterparties.

7. Systemic ERCOT Market Risk • The nature of ERCOT’s credit protocols and ‘revenue neutrality’ dictate that any counterparty defaults be transferred first to Generation then to the overall market after exactly six months. • The size of the losses may exceed the capacity of individual generators or other Market Participants to immediately absorb the loss – leading to potential cascading defaults as additional Market Participants are forced into default as a result of the inability to absorb ‘uplifts’ resulting in even greater ‘uplifts’ among fewer remaining Market Participants.

8. Potential Systemic Risk Options • Additional Market Participant Collateral Postings • Pros – decreases scenarios where exposure exceeds collateral, can be administered through current ERCOT infrastructure, does not ‘socialize’ risk, can be structured through what ever manner is easiest for each counterparty. (LC, cash, etc.) • Cons – does little to cover risk associated with extended price spikes, is expensive and unneeded almost all of the time, is restrictive on new market entrants or companies with limited access to credit, ultimately raises consumer prices. • Credit Insurance (risk transfer to a non-ERCOT entity) • Pros – transfers a portion of the risk of ‘unacceptable’ loss. • Cons – may be priced at an unacceptable level, may have restrictions which limit coverage, ‘socialized’ cost to market, can not cover potential ‘extreme’ scenarios exceeding limits.

9. Potential Systemic Risk Options (cont.) • Establishing some form of ‘credit facility’ within ERCOT if uplifted losses exceed a given threshold with all Market Participants retiring any debt over time. • Pros – does not ‘shock’ the market by uplifting (potentially) unmanageable losses immediately to Generation then the entire market – such losses are paid from the credit facility and then uplifted over time, only drawn upon if losses exceed a given predefined ‘risk tolerance level’, similar in concept to other ‘adder’ charges such as the prior Nodal Surcharge or ERCOT administration fee as a certain dollar amount per Megawatt hour, duration can be tailored to size of default. • Cons – cost allocation issues relating to uplifted losses, credit facilities have cost and rely on ERCOT creditworthiness, requires changes to ERCOT protocols and perhaps Texas law.

10. ERCOT ‘Credit Facility’ Overview • ERCOT would arrange with a financial institution to obtain immediate financing in the case of a default exceeding a pre-established threshold (e.g. $40 million) up to a maximum level (e.g. $500 million). • The credit facility could be in the form of a letter of credit, commercial paper, or other short term financing. • ERCOT’s credit rating would be used as a guarantee. • The short term financing would be rolled into debt amortized over a set period based upon default size (e.g. $50 million over 1 year, $100 million over 2 years, etc.) funded by a market surcharge similar to Nodal.

11. ERCOT ‘Credit Facility’ Advantages • A credit facility is a form of ‘self insurance’ not subject to underwriting requirements, restrictions, or exclusions. • Only drawn-down as needed with short term debt quickly replaced with a longer-term amortizing structure supported by a proposed ERCOT market surcharge. • Avoids immediate systemic risk and ‘shock’ of market short-payments which can be extended over an appropriate timeframe to match the size of loss. • Employs a common approach of paying for smaller expenses with operating income and larger with debt. • Relies on ERCOT ‘taxing authority’ to appropriately distribute losses and ensure timely debt repayment.

12. ERCOT ‘Credit Facility’ Disadvantages • Relies on ERCOT creditworthiness and without a proper cost recovery mechanism may allocate costs in an inappropriate manner among market participants. • Does not transfer risk and thus all market losses are ultimately paid by the market (similar to now). • Requires changes to ERCOT protocols and likely PUCT involvement to implement. • Is capped at a certain level so that catastrophic risk is still a possibility. • Burdens future market participants with past market losses (unless addressed in the cost recovery approach).